Unit-III: Investment Analysis

Fundamental Analysis – Economy, Industry and Company Analysis, Technical Analysis – Dow
Theory – Elliot Wave Theory – Trends and Trend Reversals - Efficient Market Theory –
Hypothesis- Forms of Market Efficiency.
1. Fundamental Analysis
Introduction
The intrinsic value of an equity share depends on a multitude of factors. The earnings of
the company, the growth rate and the risk exposure of the company have a direct bearing on the
price of the share. These factors in turn rely on the host of other factors like economic
environment in which they function, the industry they belong to, and finally companies’ own
performance.
The fundamental school of thought appraised the intrinsic value of shares through
Economic Analysis
Industry Analysis
Company Analysis
Economy-Industry-Company Analysis Framework
The analysis of economy, industry and company fundamentals constitute the main
activity in the fundamental approach to security analysis. In this era of globalization we may add
one more circle to the diagram to represent the international economy. The logic of this three
tier analysis is that the company performance depends not only on its own efforts, but also
on the general industry and economy factors. A company belongs to an industry and the
industry operates within the economy. As such, industry and economy factors affect the
performance of the company. The multitude of factors affecting the performance of a company
can be broadly classified as:
1. Economy-wide factors such as growth rate of the economy, inflation rate, foreign exchange
rates, etc. which affect all companies.
2. Industry-wide factors such as demand-supply gap in the industry, the emergence of substitute
products, changes in government policy relating to the industry, etc. these factors such as the age
of its plant, the quality of management.
3. Company specific factors such as the age of its plant, the quality of management brand image
of its products, its labour-management relations, etc. these factors are likely to make a
company’s performance quite different from that of its competitors in the same industry.
Fundamental analysis thus involves three steps:
1. Economy Analysis
2. Industry Analysis
3. Company analysis
Let us see what each of these analyses implies.
2. Economy Analysis
The performance of a company depends on the performance of the economy. If the
economy is booming, incomes rise, demand for goods increases, and hence the industries and
companies in general tend to the prosperous. On the other hand, if the economy is in recession,
the performance of companies will be generally bad.
Investors are concerned with those variables in the economy which affect the
performance of the company in which they intend to invest. A study of these economic variables
would give an idea about future corporate earnings and the payment of dividends and interest
part of his fundamental analysis.

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Growth Rates of National Income
The rate of growth of the national economy is an important variable to be considered by
an investor. GNP (gross national product), NNP (net national product) and GDP (gross domestic
product) are the different measures of the total income or total economic output of the country as
a whole. The growth rates of these measures indicate the growth rate of the economy. The
estimates of GNP, NNP and GDP and their rates are made available by the government from
time to time.
The estimated growth rate of the economy would be a pointer towards the prosperity of
the economy. An economy typically passes through different phases of prosperity known as the
different stages of the economic or business cycle. The four stages of an economic cycle are
depression, recovery, boom and recession. The stage of the economic cycle through which a
country passes has a direct impact on the performance of industries and companies.
Depression is the worst of the four stages. During a depression, demand is low and
declining. Inflation is often high and so are interest rates. Companies are forced to reduce
production, shut down plant and lay off workers. During the recovery stage, the economy begins
to revive after a depression. Demand picks up leading to more investments in the economy.
Production, employment and profits are on the increase.
The boom phase of the economic cycle is characterized by high demand. Investments and
production are maintained at a high level to satisfy the high demand. Companies generally post
higher profits. The boom phase gradually slows down. The economy slowly begins to experience
a downturn in demand, production, employment, etc. The profits of companies also start to
decline. This is the recession stage of the business cycle.
While analyzing the growth rate of the economy, an investor would do well to determine
the stage of the economic cycle through which the economy is passing and evaluate its impact on
his investment decision.
Inflation
Inflation prevailing in the economy has considerable impact on the performance of
companies. Higher rates of inflation upset business plans, lead to cost escalation and result in a
squeeze on profit margins.
On the other hand, inflation leads to erosion of purchasing power in the hands of
consumers. This will result in lower demand for products. Thus, high rates of inflation in an
economy are likely to affect the performance of companies adversely. Industries and companies
prosper during times of low inflation.
Inflation is measured both in terms of wholesale prices through the wholesale price index
(WPI) and in terms of retail prices through the consumer price index (CPI). These figures are
available on weekly or monthly basis. As part of the fundamental analysis, an investor should
evaluate the inflation rate prevailing in the economy currently as also the trend of inflation likely
to prevail in the future.
Interest Rates
Interest rates determine the cost and availability of credit for companies operating in an
economy. A low interest rate stimulates investment by making credit available easily and
cheaply. Moreover, it implies lower cost of finance for companies and thereby assures higher
profitability. On the contrary, higher interest rates result in higher cost of production which may
lead to lower profitability and lower demand.

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 The interest rates in the organized financial sector of the economy are determined by the
monetary policy of the government and the trends in money supply. These rates are thus
controlled and vary within certain ranges.
But the interest rates in the unorganized financial sector are not controlled and may
fluctuate widely depending upon the demand and supply of funds in the market. Further, long-
term interest rates differ from short-term interest rates.
An investor has to consider the interest rates prevailing in the different segments of the
economy and evaluate their impact on the performance and profitability of companies.
Government Revenue, Expenditure and Deficits
As the government is the largest investor and spender of money, the trends in government
revenue, expenditure and deficits have a significant impact on the performance of industries and
companies. Expenditure by the government stimulates the economy by creating jobs and
generating demand. Since a major portion of demand in the economy is generated by
government spending, the nature of government spending is of great importance in determining
the fortunes of many an industry.
However, when government expenditure exceeds its revenue, there occurs a deficit. This
deficit is known as budget deficit. All developing countries suffer from budget deficits as
government spend large amount of money to build up infrastructure. But budget deficit is an
important determinant of inflation, as it leads to deficit financing which fuels inflation.
Exchange Rates
The performance and profitability of industries and companies that are major importers or
exporters are considerably affected by the exchange rates of the rupee against major currencies
of the world. A depreciation of the rupee improves the competitive position of Indian products in
foreign markets, thereby stimulating exports. But it would also make imports more expensive. A
company depending heavily on imports may find devaluation of the rupee affecting its
profitability adversely.
The exchange rates of the rupee are influenced by the balance of trade deficit, the balance
of payments deficit and also the foreign exchange reserves of the country. The excess of imports
over exports is called balance of trade deficit. The balance of payments deficit represents the net
difference payable on account of all transactions such as trade, services and capital transaction. If
these deficits increase, there is a possibility that the rupee may depreciate in value.
A country needs foreign exchange reserves to meet several commitments such as
payment for imports and servicing of foreign debts. Balance of payment deficit typically leads to
decline in foreign exchange reserves as the deficit has to be met from the reserve. The size of the
foreign exchange reserve is a measure of the strength of the rupee on external account. Large
foreign exchange reserves help to increase the value of the rupee against other currencies.
The exchange rates of the rupee against the major currencies of the world arepublished
daily in the financial press. An investor has to keep track of the trend in exchange rates of rupee.
An analysis of the balance of trade deficit, balance of payments deficit and the foreign exchange
reserves will help to project the future trends in exchange rates.
Infrastructure
The development of an economy depends very much on the infrastructure available
Industry needs electricity for its manufacturing activities, roads and railways to transport raw
materials and finished goods, communication channels to keep in touch with suppliers and
customers.

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 The availability of infrastructural facilities such as power, transportation and
communication systems affects the performance of companies. Bad infrastructure leads to
inefficiencies, lower productivity, wastage and delays. An investor should assess the status of the
infrastructural facilities available in the economy before finalizing has investment plans.
Monsoon
The Indian economy is essentially an agrarian economy and agriculture forms a very
important sector of the Indian economy. Because of the strong forward and backward linkages
between agriculture and industry, performance of several industries and companies are
dependent on the performance of agriculture. Moreover, as agricultural incomes rise, the demand
for industrial products and services will be good and industry will prosper.
But the performance of agriculture to a very great extent depends on the monsoon.The
adequacy of the monsoon determines the success or failure of the agricultural activities in
India. Hence, the progress and adequacy of the monsoon becomes a matter of great concern for
an investor in the Indian context.
Economic and Political Stability
A stable political environment is necessary for steady and balanced growth. No industry
or company can grow and prosper in the midst of political turmoil. Stable long-term economic
policies are what are needed for industrial growth. Such stable policies can emanate only from
stable political systems as economic and political factors are interlinked. A stable government
with clear cut long – term economic policies will be conducive to good performance of the
economy.
Economic Forecasting
Economy analysis is the first stage of fundamental analysis and starts with an analysis of
historical performance of the economy. But as investment is a future-oriented activity, the
investor is more interested in the expected future performance of the overall economy and its
various segments. For this, forecasting the future direction of the economy becomes necessary.
Economic forecasting thus becomes a key activity in economy analysis.
The central theme in economic forecasting is to forecast the national income with its
various components. Gross national product or GNP is a measure of the national income. It is the
total value of the final output of goods and services produced in the economy. It is a measure of
the total economic activities over a specified period of time and is an indicator of the level and
rate of growth of economic activities. An investor would be particularly interested in forecasting
the various components of the national income, especially those components that have a bearing
on the particular industries and companies that he is analysing.
Forecasting Techniques
Economic forecasting may be carried out for short-term periods (up to three years),
intermediate term periods (three to five years) and long-term periods (more than five years). An
investor is more concerned about short-term economic forecasts for periods ranging from a
quarter to three years. Some of the techniques of short-term economic forecasting are discussed
below:
Anticipatory Surveys
Much of the activities in government, business, trade and industry are planned in advance
and stated in the form of budgets. Consumers also plan for their major spend in advance. To the
extent that institutions and people plan and budget for expenditures in advance, surveys of their
intentions can provide valuable input to short-term economic forecasting.

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 Anticipatory surveys are the surveys of intentions of people in government, business,
trade and industry regarding their construction activities, plant and machinery expenditures, level
of inventory, etc. Such surveys may also include the future plans of consumers with regard to
their spending on durables and non-durables. Based on the results of these surveys, the analyst
can form his own forecast of the future state of the economy.
The greatest shortcoming of the anticipatory surveys is that there is no guarantee that the
intentions surveyed will certainly materialize. The forecast based on anticipatory surveys or
surveys of intentions will be valid only to the extent that the intentions are translated into action.
Hence, the analyst cannot rely solely on these surveys.
Barometric or Indicator Approach
In this approach to economic forecasting, various types of indicators are studied to find
out how the economy is likely to perform in the future. These indicators are time series data of
certain economic variables. The indicators are classified into leading, coincidental and lagging
indicators.
The leading indicators are those time series data that reach their high points (peaks) or
their low points (troughs) in advance of the high points and low points of total economic activity.
The coincidental indicators reach their peaks and troughs at approximately the same time as the
economy, while the lagging indicators reach their turning points after the economy has already
reached its own turning points. In this method, the indicators1 act asbarometers to indicate the
future level of economic activity. However, careful examination of historical data of economic
series is necessary to ascertain which economic variables have led, lagged behind or moved
together with the economy.
The US Department of Commerce, through its Bureau of Economic Analysis, has
prepared a short list of the different indicators. Some of them are given below for illustrative
purpose.
Leading Indicators
1. Average weekly hours of manufacturing production workers
2. Average weekly initial unemployment claims
3. Contracts and orders for plant and machinery
4. Number of new building permits issued
5. Index of S and P 500 stock prices
6. Money supply (M2)
7. Change in sensitive materials prices
8. Change in manufactures’ unfilled orders (durable goods industries)
9. Index of consumer expectations
Coincidental Indicators
1. Employees on non-agricultural pay rolls
2. Personal income less transfer payments
3. Index of industrial production
4. Manufacturing and trade sales
Lagging Indicators
1. Average duration of unemployment
2. Ratio of manufacturing and trade inventories to sales
3. Average prime rate
4. Commercial and industrial loans outstanding
Change in consumer price index for services

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 Of the three types of indicators, leading indicators are more useful for economic
forecasting because they measure something that foreshadows a change in economic activity.
The indicator approach has its own limitations. It is useful in forecasting the direction of
the change in aggregate economic activity, but it does not indicate the magnitude or duration of
the change. Further, the leading indicators may give false signals. Moreover, different leading
indicators may give conflicting signals. The indicator approach becomes useful for economic
forecasting only if data collection and presentation are done quickly. Any delay in presentation
of data defeats the purpose of the indicators.
3. Econometric Model Building
This is the most precise and scientific of the different forecasting techniques. This
technique makes use of Econometrics, which is a discipline that applies mathematical and
statistical techniques to economic theory.
In the economic field we find complex interrelationships between the different economic
variables. The precise relationships between the dependent and independent variables are
specified in a formal mathematical manner in the form of equations. The system of equations is
then solved to yield a forecast that is quite precise.
In applying this technique, the analyst is forced to define learly and precisely the
interrelationships between the economic variables. The accuracy of the forecast derived from this
technique would depend on the validity of the assumptions made by the analyst regarding
economic interrelationships and the quality of his input data.
Econometric models used for economic forecasting are generally complex. Vast amounts
of data are required to be collected and processed for the solution of the model. This may cause
delay in making the results available. Undue delay may render the results obsolete for purpose of
forecasting.
Opportunistic Model Building
This is one of the most widely used forecasting techniques. It is also known as GNP
model building or sectoral analysis.
Initially, an analyst estimates the total demand in the economy, and based on this he
estimates the total income or GNP for the forecast period. This initial estimate takes into
consideration the prevailing economic environment such as the existing tax rates, interest rates,
rate of inflation and other economic and fiscal policies of the government.
After this initial forecast is arrived at, the analyst now begins building up a forecast of the
GNP figure by estimating the levels of various components of GNP. For this, he collects the
figures of consumption expenditure, gross private domestic investment, government purchase of
goods and services and net exports. He adds these figures together to arrive at the GNP forecast.
The two GNP forecasts arrived at by two different methods will be compared and
necessary adjustments will be made to bring the two forecasts into line with each other.
The opportunistic model building approach makes use of other forecasting techniques to
build up the various components. A vast amount of judgment and ingenuity is also applied to
make the overall forecast reliable.
Economic forecasting is an extremely complex and difficult process. No method is
expected to give accurate results. The investor must evaluate all economic forecasts critically
before making his investment decision.
Economy analysis is an important part of fundamental analysis. It gives the investor an
overall picture of the expected performance of the economy in the near future. This is a valuable
input to investment decision-making.

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 4. Industry Analysis
An industry is a group of firms that have similar technological structure of production
and produce similar products. For the convenience of the investors, the broad classification of the
industry is given in financial dailies and magazines. Companies are distinctly classified to give a
clear picture about their manufacturing process and products. The table gives the industry wise
classification given in Reserve Bank of India Bulletin.
Industry Groups
Industries
1 Food Products
2 Beverages, Tobacco and Tobacco products
3 Textiles
4 Wood and wood products
5 Leather and leather products
6 Rubber and plastic products
7 Chemical and chemical products
8 Non-metallic mineral products
9 Basic metals, alloys and metal products
10 Machinery and Machine tools
11 Transport equipment and parts
12 other Miscellaneous manufacturing industries
The table shows that each industry is different from the other. Textile industry is entirely
different from the steel industry or the power industry in its product and process.
These industries can be classified on the basis of the business cycle i.e., classified according
reactions to the different phases of the business cycle. They are classified into growth, cyclical,
defensive and cyclical growth industry.
Growth Industry
The growth industries have special features of high rate of earnings and growth in
expansion, independent of the business cycle. The expansion of the industry mainly depends on
the technological change. For instance, inspite of the recession in the Indian economy in 1997-
98, there was a spurt in the growth of information technology. It defied the business cycle and
continued to grow. Like wise in every phase of the history certain industries like colour
televisions, pharmaceutical and telecommunication industries have shown remarkable growth.
Cyclical Industry
The growth and the profitability of the industry move along with the business cycle.
During the boom period they enjoy growth and during depression they suffer a setback. For
example, the white goods like fridge, washing machine and kitchen range products command a
good market in the boom period and the demand for them slackens during the recession
Defensive Industry
Defensive industry defies the movement of the business cycle. For example, food and
shelter are the basic requirements of humanity. The food industry withstands recession and
depression. The stocks of the defensive industries can be held by the investor for income earning
purpose. They expand and earn income in the depression period too, under the government’s
umbrella of protection and are counter cyclical in nature.
Cyclical Growth Industry
This is new type of industry that is cyclical and at the same time growing. For example,
the automobile industry experiences periods of stagnation, decline but they grow tremendously.

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The change in technology and introduction of new models help the automobile industry to
resume their growth path.
Industry Life Cycle
The industry life cycle theory is generally attributed to Julius Grodensky. The life cycle
of the industry is separated into four well defined stages such as
➢Pioneering stage
➢Rapid growth stage
➢Maturity and stabilization stage
➢Declining stage
Pioneering Stage
The prospective demand for the product is promising in this stage and the technology of
the product is low. The demand for the product attracts many producers to produce the particular
product. There would be severe competition and only fittest companies survive this stage. The
producers try to develop brand name, differentiate the product and create a product image. This
would lead to non-price competition too. The severe competition often leads to the change of
position of the firms in terms of market shares and profit. In this situation, it is difficult to select
companies for investment because the survival rate is unknown.
Rapid Growth Stage
This stage starts with the appearance of surviving firms from the pioneering stage. The
companies that have withstood the competition grow strongly in market share and financial
performance. The technology of the production would have improved resulting in low cost of
production and good quality products. The companies have stable growth rate in this stage and
they declare dividend to the share holders. It is advisable to invest in the shares of these
companies. The pharmaceutical industry has improved its technology and the top companies in
this sector are giving dividend to the shareholders. Likewise power industry and
telecommunication industry can be cited as examples of expansion stage. In this stage the growth
rate is more than the industry’s average growth rate.
Maturity and Stabilization Stage
In the stabilization stage, the growth rate tends to moderate and the rate of growth would
be more or less equal to the industrial growth rate or the gross domestic product growth rate.
Symptoms of obsolescence may appear in the technology. The keep going, technological
innovations in the production process and products should be introduced. The investors have to
closely monitor the events that take place in the maturity stage of the industry.
Declining Stage
In this stage, demand for the particular product and the earnings of the companies in the
industry decline. Now-a-days very few consumers demand black and white T.V. innovation of
new products and change in consumer preferences lead to this stage. The specific feature of the
declining stage is that even in the boom period; the growth of the industry would be low and
decline at a higher rate during the recession. It is better to avoid investing in the shares of the low
growth industry even in the boom period. Investment in the shares of these types of companies
leads to erosion of capital
5. Factors to be Considered
Apart from industry life cycle analysis, the investor has to analyse some other factors too.
They are as listed below
 Growth of the industry
 Cost structure and profitability

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  Nature of the product
 Nature of the competition
 Government policy
 Labour
 Research and development
Growth of the Industry
The historical performance of the industry in terms of growth and profitability should be
analysed. Industry wise growth is published periodically by the Centre for Monitoring Indian
Economy. The past variability in return and growth in reaction to macro economic factors
provide an insight into the future. Even though history may not repeat in the exact manner,
looking into the past growth of the industry, the analyst can predict the future. The information
technology industry has witnessed a tremendous growth in the past so also the scrip prices of the
IT industry. With the Y2K millennium bug creating a huge business opportunity even beyond the
year 2000, the sector is expected to maintain its growth momentum.
Cost Structure and Profitability
The cost structure, that is the fixed and variable cost, affects the cost of production and
profitability of the firm. In the case of oil and natural gas industry and iron and steel industry the
fixed cost portion is high and the gestation period is also lengthy. Higher the fixed cost
component, greater sales volume is required to reach the firm’s breakeven point. Once the
breakeven point is reached and the production is on the track, the profitability can be increased
by utilizing the capacity to full. Once the maximum capacity is reached, again capital has to
invest in the fixed equipment. Hence, lower the fixed cost, adjustability to the changing demand
and reaching the break even points are comparatively easier.
Nature of the Product
The products produced by the industries are demanded by the consumers and other
industries. If industrial goods like pig iron, iron sheet and coils are produced, the demand for
them depends on the construction industry. Likewise, textile machine tools industry produces
tools for the textile industry and the entire demand depends upon the health of the textile
industry. Several such examples can be cited. The investor has to analyse the condition of related
goods producing industry and the end user industry to find out the demand for industrial goods.
In the case of consumer goods industry, the change in the consumers’ preference, technological
innovations and substitute products affect the demand. A simple example is that the demand for
the ink pen is affected by the ball point pen with the change in the consumer preference towards
the easy usage of pen.
Nature of the Competition
Nature of competition is an essential factor that determines the demand for the particular
product, its profitability and the price of the concerned company scrips. The supply may arise
from indigenous producers and multinationals. In the case of detergents, it is produced by
indigenous manufactures and distributed locally at a competitive price. This poses a threat to the
company made products. The multinational are also entering into the field with sophisticated
product process and better quality product. Now the companies’ ability to withstand the local as
well as the multinational competition counts much. If too many firms are present in the
organized sector, the competition would be severe. The competition would lead to a decline in
the price of the product. The investor before investing in the scrip of a company should analyse
the market share of the particular company’s product and should compare it with the top five
companies.

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Government Policy
The government policies affect the very nerve of the industry and the effects differ from
industry to industry. Tax subsidies and tax holidays are provided for export oriented products.
Government regulates the size of the production and the pricing of certain products. The sugar,
fertilizer and pharmaceutical industries are often affected by the inconsistent government polices.
Control and decontrol of sugar price affect the profitability of the sugar industry. In some cases
entry barriers are placed by the government. In the airways, private corporate are permitted to
operate the domestic flights only. When selecting an industry, the government policy regarding
the particular industry should be carefully evaluated. Liberalization and delicensing have brought
immense threat to the existing domestic industries in several sectors.
Labor
The analysis of labor scenario in a particular industry is of great importance. The number
of trade unions and their operating mode has impact on the labour productivity and
modernization of the industry. Textile industry is known for its militant trade unions. If the trade
unions are strong and strikes occur frequently, it would lead to fall in the production. In an
industry of high fixed cost, the stoppage of production may lead to loss.
When trade unions oppose the introduction of automation, in the product market the
company may stand to lose with high cost of production. The unhealthy labour relationship leads
to loss of customers’ goodwill too.
Skilled labour is needed for certain industries. In the case of Indian labour market, even
in computer technology or in any other industry skilled and well-qualified labour is available at a
cheaper rate. This is one of the many reasons attracting the multinationals to set up companies in
India.
Research and Development
For any industry to survive the competition in the national and international markets,
product and production process have to be technically competitive. This depends on the R & D
in the particular company or industry. Economies of scale and new market can be obtained only
through R & D. the percentage of expenditure made on R & D should be studied diligently
before making an investment.
Pollution Standards
Pollution standards are very high and strict in the industrial sector. For some industries it
may be heavier than others; for example, in leather, chemical and pharmaceutical industries the
industrial effluents are more.
SWOT Analysis
The above mentioned factors themselves would become strength, weakness, opportunity
and threat (SWOT) for the industry. Hence, the investor should carry out a SWOT analysis for
the chosen industry. Take for instance, increase in demand for the industry’s product becomes its
strength, presence of numerous players in the market, i.e. competition becomes the threat to a
particular company in the respective industry. The progress in the research and development in
that particular industry is an opportunity and entry of multinationals in the industry and cheap
imports of the particular products are threat to that industry. In this way the factors have to be
arranged and analysed. To make the industry analysis more explanatory it has been carried out
on the pharmaceutical industry and SWOT analysis results are also given.
6. Company Analysis
In company analysis analysts consider the basic financial variables for the estimation of
the intrinsic value of the company. These variables contain sales, profit margin, tax rate,

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depreciation, asset utilization, sources of financing and other factors. The conduction of further
analysis of company include the competitive position of the company in the industry,
technological changes, management, labor relations, foreign competition and so on.
How to do the Company Analysis
Company analysis actually provides the indication of the estimated value & potential of
the company along with the comprehension of its financial variables. Common stock can be
valued by the investors by using dividend discount model. Similarly earnings multiplier model
can be used for estimation of intrinsic value for a short run. Intrinsic value (or estimated value) is
the product of expected multiplier or P/E ratio and the estimated earnings per share (EPS).
Estimated Value of Stock = Vo = Estimated EPS x Expected P/E Ratio
Relative valuation techniques are used by many investors in which comparison of P/E ratio, P/S
ratio and P/B ratio of the company is made with many benchmarks in order to ascertain the
relative value of the company. Another effective way adopted by investors is to find out whether
the stock is properly valued, undervalued or overvalued without being much exact about the
absolute amount.
Majority of investors considers the P/E ratio and the Earning Per Share while accessing
the value of the stocks of company.
The Financial Statements
Major financial data about company is obtained from its financial statements while
doing the process of company analysis. Following are included in the category of financial
statements.
 Balance Sheet
 Income Statement
 Cash Flow Statement
The Balance Sheet
The balance sheet represents the Portfolio of assets and liabilities & owner’s equity of a
company at particular point of time. The accounting conventions dictate the amounts at which
items are carried on the balance sheets. Cash is the real dollar amount while marketable
securities can be at market value or cost. Assets and stockholders equity are based on the book
value. The careful analysis of the balance sheet of a company is important for the investors. The
investors want to know those companies which are really profitable and are different from the
ones which pump up their performance by taking too much debt whose recovery is a big issue.
Balance sheet is really important to analyze while doing company analysis for making
investment.
Income Statement
In Company analysis process Investors frequently use income statement to evaluate the
current performance of management and forecasting of the future profitability of the company.
The flows for certain period (one year) are represented by the income statement.
The investors are more interested for the After-tax net income item of the income statement
which is divided by the number of common shares outstanding to ascertain the earnings per
share. The success of the company is viewed from the earnings from its continuing operations
and these earnings are mostly reported as earnings in the financial press. Nonrecurring income is
kept separate from the continuing income.
The Cash Flow Statement
The cash flow statement is the third financial statement of the company which includes
the items of the balance sheet and income statement as well as other ones. It provides the picture

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of the travelling of the cash in and out of the company. There are three part of cash flow
statement which are
1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
The quality of earnings is examined by the investors with the help of cash flow statement.
For example if inventories are increasing more quickly than sales this indicate serious problem
by likely softening of the demand. Similarly cutting back of capital expenditures by a company
indicate problem. Moreover it is also problematic if the accounts receivables increase more
quickly than the sales which shows the poor recovery of the debts by the company.
Certifying the Statements
The Generally Accepted Accounting Principles (GAAP) provides the basis to derive
earnings from the balance sheet. Accounting professionals developed certain rules on the basis of
historical costs which are followed by the company. The earnings in the financial statements are
certified by an auditor from an independent accounting firm.
Reading Footnotes
There are certain foot notes at the end of the financial statements that should be
considered by the investors which mostly gives the information on the accounting methods being
used and how income is reorganized etc. These footnotes may easily put the company analysis
process in the right direction.
Analyzing Profitability of a Company
There are many factors that collectively provide basis for the culmination of the EPS in
the company. Key financial ratios are considered to examine these determining factors. The
increasing or decreasing profitability of a company is ascertained by examining the components
of the EPS.
EPS = ROE x Book Value per Share
Where book value per share is the accounting value of equity of shareholders on the basis
of per share and ROE is the return on equity. Book value changes slowly so ROE is the main
variable that should be focused. These ratios are calculated as follow.
EPS = Net Income after Taxes / Outstanding Shares
Book Value per Share = Shareholder’s Equity / Outstanding Shares
ROE = Net Income after Taxes / Stockholder’s Equity
ROE reflects the accounting rate of return that stockholders are in on their part of the
entire capital employed to finance the company. The accounting value of the stockholder’s
equity is measured by the book value per share.
The earnings growth and dividend growth is determined by the ROE which is the key
component. Many important variables collectively provide basis of ROE. The investors and
analysts try to split the ROE into its important components for the identification of the severe
effects on the ROE and forecasting of the future trends in ROE.
Analyzing Return on Equity (ROE)
ROE = ROA x Leverage
ROA is an important complement of return on investment (ROE) and is used to
measure the profitability of a company. ROE measures the return to stockholders while ROA
measures the return on assets. The effects of leverage must be considered by going from ROA to
ROE. The measure of how a company fiancé its assets, is referred to as leverage ratio. The
company can either takes debt or utilizes only equity for financing its assets. The debt is

12
 although cheaper but more risky due to the associated regular interest payments which must be
paid consistently from preventing bankruptcy. The returns to shareholders are either magnified
with leverage or diminish with it. By the judicious use of debt financing, certain ROA can be
magnified into higher ROE. On the other hand ROE is lowered than ROA by the injudicious use
of Debt.
Leverage = Total Assets / Stockholder’s Equity
Analyzing Return on Assets (ROA)
One of significant measure of the profitability of the company is the ROA. ROA is
product of two factors
ROA = Net Income Margin x Turnover
Net Income Margin = Net Income / Sales
Turnover = Sales / Total Assets
The net income margin which affects the ROA measures earning power of a company on
its sales. Efficiency is measured by the asset turnover. The ROA measures the profitability of a
company by showing how efficiently & effectively the assets of a company are used. It is clear
that the return is better when there is higher net income for a certain amount of assets.
Earnings Estimates
The estimated EPS is used by the investor to value the stock. Current stock price is a
function of the price earnings ratio (P/E) and the future earnings estimate. The investor required
following three things when conducting fundamental security analysis using EPS.
 Ascertaining of how to get an earnings estimate
 Viewing the accuracy of any earning estimate acquired
 Comprehending the role of earnings surprises in influencing stock prices
P/E Ratio
The price earnings ratio is very important consideration in doing company analysis. The
P/E ratio shows how much of per dollar earnings investors presently are volitionally to pay for a
stock. The market’s summary evaluation of the prospects of the company is reflected by P/E
ratio.
Determinants of P/E Ratio
Conceptually the price earnings ratio (P/E) is a function of three factors
P/E = D1/E1
k–g
Where k = required rate of return for stock
g = Expected growth rate in dividends
D1/E1 = expected dividend payout ratio
These three factors and their likely changes should be considered by the investors who
are trying to determine the P/E ratio that will prevail for certain stock.
 The higher expected payout ratio indicates the higher the P/E ratio provided other things
being equal. In fact the others are rarely equal. The expected growth rate in earnings &
dividends (g) will likely decline if the payout ratio rises. This will severely affect P/E ratio.
The reason for this decline is the availability of the lesser funds for the purpose of
reinvestment in the company.
 There is inverse relationship between k and P/E ratio. The increase k will reduce the P/E ratio
and similarly decrease in the k will enhance the P/E ratio provided other things being equal.
The reason behind this is that required rate of return is the discount rate. Discount rates and
P/E ratio moves inversely to each other.

13
 g and P/E are directly related. The increase in the g will enhance the P/E ratio provided other
things being equal.
Company analysis is also known as the fundamental analysis of a company in which we
analyze the company profile, securities, profitability, goals, values and objectives, etc.
http://www.businessstudynotes.com/finance/company-analysis-introduction/
7. Technical Analysis
The share price movement is analyzed broadly with two approaches, namely,
fundamental approach and the technical approach. Fundamental approach analyses the share
prices on the basis of economic, industry and company statistics. If the price of the share is lower
than its intrinsic value, investor buys it. But, if he finds the price of the share higher than the
intrinsic value he sells and gets profit. The technical analyst mainly studies the stock price
movement of the security market. If there is an uptrend in the price movement investor may
purchase the scrip. With the onset of fall in price he may sell it and move from the scrip.
Basically, technical analysts and the fundamental analysts aim at good return on investment.
Technical Analysis
It is a process of identifying trend reversals at an earlier stage to formulate the buying and
selling strategy. With the help of several indicators they analyzed the relationship between price
- volume and supply-demand for the overall market and the individual stock. Volume is
favorable on the upswing i.e. the number of shares traded is greater than before and on the
downside the number of shares traded dwindles If it is the other way round, trend reversals can
be expected.
Assumptions
1) The market value of the scrip is determined by the interaction of supply and demand.
2) The market discounts everything. The price of the security quoted represents the hopes, fears
and inside information received by the market players. Inside information regarding the issuing
of bonus shares and right issues may support the prices. The loss of earnings and information
regarding the forthcoming labour problem may result in fall in price. These factors may cause a
shift in demand and supply, changing the direction of trends.
3) The market always moves in trend. Except for minor deviations, the stock prices move in
trends. The price may create definite patterns too. The trend may lie either increasing or
decreasing. The trend continues for some time and then it reverses.
4) Any layman knows the fact that history repeats itself. It is true to the stock market also. In the
rising market investors’ psychology have tip beats and they purchase the shares in greater
volumes, driving the prices higher. At the same time, in the down trend they may be very eager
to get out of the market by selling them and thus plunging the share price further. The market
technicians assume that past prices predict the future.
History of Technical Analysis
The technical analysis is based on the doctrine given by Charles H. Dow in 1884, in the
Wall Street Journal. He wrote a series of articles in the Wall Street Journal A.J. Nelson, a close
friend of Charles Dow formalized the Dow Theory for economic forecasting.
The analysts used charts of individual stocks and moving averages in the early 1920’s.
Later on, with the aid of calculators and computers, sophisticated techniques came into vogue.
Technical Tools
Generally used technical tools are Dow Theory, volume of trading, short selling, odd lot
trading, bars and line charts, moving averages and oscillators. In this section some of the above
mentioned tools are analyzed.

14
 10. Dow Theory
Dow developed his theory to explain the movement of the indices of Dow Jones
Averages. He developed the theory on the basis of certain hypotheses. The first hypothesis is
that, no single individual or buyer can influence the major trend of the market.
However, an individual investor can affect the daily price movement by buying or selling
huge quantum of particular scrip. The intermediate price movement also can be affected to a
lesser degree by an investor.
His second hypothesis is that the market discounts everything. Even natural calamities
such as earthquake, plague and fire also get quickly discounted in the market. The Pokhran blast
affected the share market for a short while and then the market returned back to normalcy.
His third hypothesis is that the theory is not infallible. It is not a tool to beat the market
but provides a way to understand it better.
The theory According to Dow Theory the trend is divided into primary, intermediate and
short term trend. The primary trend may be the broad upward or downward movement that may
last for a year or two. The intermediate trends are corrective movements, which may last for
three weeks to three months. The primary trend may be interrupted by the intermediate trend.
The short term trend refers to the day to day price movement. It is also known as oscillators or
fluctuations. These three types of trends are compared to tide, waves and ripples of the sea.
11. Elliot wave theory
The Elliott Wave Principle is a form of technical analysis that traders use to analyze
financial market cycles and forecast market trends by identifying extremes in investor
psychology, highs and lows in prices, and other collective factors. Elliott used the different stock
market indicators to discover that the ever-changing path of stock market prices reveals a
structural design that in turn reflects a basic harmony found in nature. Based on this research, he
developed a rational system of stock price analysis.
BASIC PRINCIPLES
 According to the wave principle, every next move is always related to previous waves and is the
reason for the upcoming market changes. A trader operates under the influence of the previous
changes seen at the market, which in turn make him take subsequent decisions. As mentioned
above, every action at the financial market is followed by reaction. These structures link together
to form patterns. Since patterns are repetitive they have predictive value.
THE FIVE WAVE PATTERN
Markets movements ultimately take the form of five waves. Three of these waves, which
are labeled 1, 3 and 5, actually affect the directional movement. They are separated by two
countertrend interruptions which are labeled 2 and 4.

15
WAVE MODE
1) There are two modes of wave development: motive and corrective.
2) Motive waves have a five wave structure, while corrective waves have a three wave structure.
3) Motive waves constitute the basis for the five wave pattern. Their structures are called
"motive" because they powerfully impel the market.
4) Waves 2 and 4 are corrective waves because they move against this bigger trend and form 1
and 3 waves.
5) After completion of 5 waves cycle the wave three begin to form. These corrective waves are
denoted by letters a,b,c.

WAVE PERSONALITY
Wave 1
About a half of first waves are parts of the "basing" process. As a rule, wave 1 is the
shortest of impulse waves.
Wave 2
Second waves often retrace of wave one but still are held on the first wave.
Wave 3
Third wave is usually the longest and is characterized by dynamic growth. Third waves
usually generate the greatest volume and price movement. They produce breakouts,
"continuation" gaps, creating large gains in the market. Wave 3 cannot be the shortest of the 5
impulse waves.
Wave 4
Wave 4 has a complex structure and just as the wave 2 is flat in the form of
consolidation. The bottom of the fourth wave will never be equal to the peak of the first wave.
5-ci Wave
Waves 5 are always less dynamic than the third waves. During the formation of this wave
technical indicators show declining strength and appear to be negative divergence indicating a
weakening trend upward.
A Wave
Wave A appears once the movement is divided into 5 smaller waves and the trade
volume at the market increases in a reverse trend.
B Wave
During the downtrend this wave reflects a price upward rebound. Wave B is usually a
low volume of turnover, may rise to reach and even exceed the previous peak of wave 5.
C Wave
Wave C is often reduced below the bottom of a wave A. Head and shoulders pattern is
formed as a result of drawing a trend line under the bottom of wave 4 and wave A.

16
DIAGONL TRAINGLES
A diagonal triangle is a motive pattern yet not an impulse, as it has one or two corrective
characteristics. Such patterns are seen on the fifth and the final wave position. As with impulses,
no reactionary sub wave fully retraces the preceding actionary subwave, and the third subwave is
never the shortest. However, diagonal triangles are the only five-wave structures in the main
trend direction within which wave 4 almost always overlaps the price territory of wave 1.

ENDING DIAGONAL
An ending diagonal is a special type of wave that occurs primarily in the fifth wave
position at times when the preceding move has gone "too far too fast." A very small percentage
of ending diagonals appear in the C wave position of A-B-C formations. In double or triple peaks
they appear only as the final "C" wave. Ending triangles are found at the termination points of
larger patterns, indicating a further market movement.

LEADING DIAGONAL
When diagonal triangles occur in the wave 5 or C position, they take the 3-3-3-3-3 shape.
It has recently come to light that a variation on this pattern occasionally appears in the wave 1
position of impulses. The characteristic overlapping of waves 1 and 4 remains as in the ending
diagonal triangle. However, the subdivisions are different, tracing out a 5-3-5-3-5 pattern.

17
ZIGZAGS AND CORRECTIVE WAVES
ZIGZAGS(5-3-5)
A zigzag is a simple three-wave declining pattern labeled A-B-C. The subwave sequence
is 5-3-5, and the top of wave B is noticeably lower than the start of wave A.

FLATS (3-3-5)
As shown in a figure below, a flat correction differs from a zigzag in that the sub wave
sequence is 3-3-5. Since the first active wave, wave A, lacks sufficient downward force to unfold
into a full five waves as it does in a zigzag, the B wave reaction unfolds in 3 waves. Wave B
rises to reach the peak of the wave A indicating a strong market trend.

TRIANGLES (3-3-3-3-3)
Triangles reflect a balance of forces, causing a sideways movement that is usually
associated with decreasing volume and volatility. Triangles contain five overlapping waves that
subdivide 3-3-3-3-3 and are labeled a-b-c-d-e. A triangle is outlined by connecting the
termination points of waves a and c, and b and d. Wave c can undershoot or overshoot the a-c
line.
Ascending triangle

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Reverse Symmetrical triangle

DOUBLE AND TRIPLE THREES

Elliott called sideways combinations of corrective patterns "double threes" and "triple
threes". A double or triple three is a combination of simpler types of corrections, including the
various types of zigzags, flats and triangles. As with double and triple zigzags, each simple
corrective pattern is labeled W, Y and Z. The reactionary waves, labeled X, can take the shape of
any corrective pattern but are most commonly zigzags.

ORTHODOX TOPS AND BOTTOMS

Sometimes the end of a pattern differs from the price extreme level. In such cases, the
end of the pattern is called the "orthodox" top or bottom in order to differentiate it from the
actual price maximum or minimum that occurs inside the pattern.
12. Trends and trend reversals
Trend
Trend is the direction of movement. The share prices can either increase or fall or remain
flat. The three directions of the share price movements are called as rising, falling and flat trends.
The point to be remembered is that share prices do not rise or fall in a straight line. Every rise or
fall in price experiences a counter move. If a share price is increasing, the countermove will be a
fall in price and vice-versa. The share prices move in zigzag manner.
The trend lines are straight lines drawn connecting either the tops or bottoms of the share
price movement. To draw a trend line, the technical analyst should have at least two tops or
bottoms. The following figure shows the trend lines.

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Trend Reversal
The rise or fall in share price cannot go on forever. The share price movement may
reverse its direction. Before the change of direction, certain pattern in price movement emerges.
The change in the direction of the trend is shown by violation of the trend line. Violation of the
trend line means the penetration of the trend line.
If a scrip price cuts the rising trend line from above, it is a violation of trend line and
signals the possibility of fall in price. Like – wise if the scrip pierces the trend line from below
this signal the rise in price.
Primary Trend
The security price trend may be either increasing or decreasing. When the market exhibits
the increasing trend, it is called bull market. The bull market shows three clear cut peaks. Each
peak is higher than the previous peak. The bottoms are also higher than the previous bottoms.
The reactions following the peak used to halt before the previous bottoms.
The phases leading to the three peaks are revival, improvement in corporate profit and
speculation. The revival period encourages more and more investors to buy scrip’s their
expectations about the future being high. In the second phase, increased profits of corporate
would result in further price rise. In the third phase, prices advance due to inflation and
speculation. The figure gives the three phases of bull market.
The reverse is true with the bear market. Here, the first phase of fall starts with the
abandonment of hopes. The chances of prices moving back to the previous high level seemed to
be low. This would result in the sale of shares. In the second phase, companies are reporting
lower profits and dividends. This would lead to selling pressure.
The final phase is characterized 1’ the distress sale of shares. During the bear phase of
1996, in the Bombay Stock Exchange more than 2/3 of stocks were inactive. Most of the scrip’s
were sold below their par values. The figure gives the bear market. Here the tops and bottoms are
lower than the previous ones. The bull and bear phases of the Indian stock market are given in
Figure.

20
The Secondary Trend
The secondary trend or the intermediate trend moves against the main trend and leads to
correction. In the bull market the secondary trend would result in the fall of about 33-66% of the
earlier rise. In the bear market, the secondary trend carries the price upward and corrects the
main trend. The correction ivu1d be 33% to 66% of the earlier fall. Intermediate trend corrects
the overbought and oversold condition. It provides the space to the market. Compared to the time
taken for the primary trend, secondary trend is swift and quicker.

Minor Trends
Minor trends or tertiary moves are called random wriggles. They are simply the daily
price fluctuations. Minor trend tries to correct the secondary trend movement. It is better for the
investors to concentrate on the primary or secondary trends than on the minor trends. The chartist
plots the scrip’s price or the market index each day to trace the primary and secondary trend.
Support and Resistance Level
Anybody interested in the technical analysis should know the support and resistance
level. A support level exists at a price where considerable demand for that stock is expected to
prevent further fall in the price level. The fall in the price may be halted for the time being or it
may result even in price reversal. In the support level, demand for the particular scrip is
expected.
In the resistance level, the supply of scrip would be greater than the demand and further
rise in price is prevented. The selling pressure is greater and the increase in price is halted for the
time being.

21
 Support and resistance usually occur whenever the turnover of a large number of shares
tends to be concentrated at several price levels. When the stock touches a certain level and then
drops, this is called resistance and if the stock reaches down to certain level and then rises there
exists a support. The levels constantly switch from one to another i.e. from support to resistance,
or from resistance to support. The figures show the support and resistance level.
This can be explained numerically say, for example, if a scrip price hovers around 150
for some weeks then it may rise and reach ` 210. At this point the price halts and then falls back.
The scrip keeps on falling back to around its original price ` 150 and halts. Then it moves
upward. In this case ` 150 becomes the support level. At this point, the scrip is cheap and
investors buy it and demand makes the price move upward. Whereas ` 210 becomes the
resistance level, the price is high and there would be selling pressure resulting in the decline of
the price.

If the scrip price reverses the support level and moves downward, it means that the
selling pressure has overcome the potential buying pressure, signaling the possibility of a further
fall in the value of the scrip. It indicates the violation of the support level and bearish market.
If the scrip penetrates the previous top and moves above, it is the violation of resistance
level. At this point, buying pressure would be more than the selling pressure. If the scrip was to
move above the double top or triple top formation, it indicates bullish market.
The support and the resistance level need not be formed only on tops or bottoms. They
can be on the trend lines or gaps of the chart. Gaps are defined as those points or price levels
where the scrip has not changed hands. In the rising or falling price level gaps are formed. If the
prices are in the upward move and the high of any day is lower than the next day’s low, the gap
is said to have occurred.
For example, if the high price of the Instant Company’s scrip on March 1st is ` 200 and
on March 2nd low is 225, a gap is said to have occurred on the bar chart. This indicates that the
stock is not traded between the level ` 200 and ` 225. This gap indicates further rise in price
level. Likewise in a falling price, a gap is formed if the low price on day 1 is higher than the high
price of day 2. Suppose the low price on Monday is ` 150 and the high price on the Tuesday is `
130, a gap is said to have occurred and indicates that there was no transaction between the level
of ` 150 and ` 130.
Efficient market theory-Hypothesis-Forms hypothesis
Stock prices are determined by a number of factors such as fundamental factors, technical
factors and psychological factors. The behavior of stock prices is studied with the help of
different methods such as fundamental analysis and technical analysis. Fundamental analysis

22
seeks to evaluate the intrinsic value of securities by studying the fundamental factors affecting
the performance of the economy, industry and companies. Technical analysis believes that the
past behavior of stock prices gives an indication of the future behavior. It tries to study the
patterns in stock price behavior through charts and predict the future movement in prices. There
is a third theory on stock price behavior which questions the assumptions of technical analysis.
The basic assumption in technical analysis is that stock pie movement is quite orderly and
not random. The new theory questions this assumption. From the results of several empirical
studies on stock price movements, the advocates of the new theory assert that share price
movements are random. The new theory came to be known as Random Walk Theory because of
its principal contention that share price movements represent a random walk rather than an
orderly movement.
Random Walk Theory
Stock price behavior is explained by the theory in the following manner. A change occurs
in the price of a stock only because of certain changes in the economy, industry or company.
Information about these changes alters the stock prices immediately and the stock moves to a
new level, either upwards or downwards, depending on the type of information. This rapid shift
to a new equilibrium level whenever new information is received is recognition of the fact that
all information which is known is fully reflected in the price of the stock. Further change in the
price of the stock will occur only as a result of some other new piece of information which was
not available earlier. Thus, according to this theory, changes in stock prices show independent
behavior and are dependent on the new pieces of information that are received but within
themselves are independent of each other. Each price change is independent of other price
changes because each change is caused by a new piece of information.
The basic premise in random walk theory is that the information on changes in the
economy, industry and company performance is immediately and fully spread so that all
investors have full knowledge of the information. There is an instant adjustment in stock prices
either upwards or downwards. Thus, the current stock price fully reflects all available
information on the stock. Therefore, the price of a security two days ago can in no way help in
speculating the price two days later. The price of each day is independent. It may be unchanged,
higher or lower from the previous price, but that depends on new pieces of information being
received each day.
The random walk theory presupposes that the stock markets are so efficient and
competitive that there is immediate price adjustment. This is the result of good communication
system through which information can be spread almost anywhere in the country
instantaneously. Thus, the random walk theory is based on the hypothesis that the stock markets
are efficient. Hence, this theory later came to be known as the efficient market hypothesis
(EMH) or the efficient market model.
The Efficient Market Hypothesis
This hypothesis states that the capital market is efficient in processing information. An
efficient capital market is one in which security prices equal their intrinsic values at all times,
and where most securities are correctly priced. The concept of an efficient capital market has
been one of the dominant themes in academic literature since the 1960s. According to Elton and
Gruber, “when someone refers to efficient capital markets, they mean that security prices fully
reflect all available information”.’ According to Eugene Fama,2 in an efficient market, prices
fully reflect all available information. The prices of securities observed at any time are based on
correct evaluation of all information available at that time.

23
 The efficient market model is actually concerned with the speed with which information
is incorporated into security prices. The technicians believe that past price sequence contains
information about the future price movements because they believe that information is slowly
incorporated in security prices. This gives technicians an opportunity to earn excess returns by
studying the patterns in price movements and trading accordingly.
Fundamentalists believe that it may take several days or weeks before investors can fully
assess the impact of new information. As a consequence, the price may be volatile for a number
of days before it adjusts to a new level. This provides an opportunity to the analyst who has
superior analytical skills to earn excess returns.
The efficient market theory holds the view that in an efficient market, new information is
processed and evaluated as it arrives and prices instantaneously adjust to new and correct levels.
Consequently, an investor cannot consistently earn excess returns by undertaking fundamental
analysis or technical analysis.
Forms of Market Efficiency
The capital market is considered to be efficient in three different forms: the weak form,
semi-strong form and the strong form. Thus, the efficient market hypothesis has been subdivided
into three forms, each dealing with a different type of information. The weak form deals with the
information regarding the past sequence of security price movements, the semi-strong form deals
with the publicly available information, while the strong form deals with all information, both
public and private (or inside).
The different forms of efficient market hypothesis have been tested through several
empirical studies. The tests of the weak form hypothesis are essentially tests of whether all
information contained in historical prices of securities is fully reflected in current prices. Semi-
strong form tests of the efficient market hypothesis are tests of whether publicly available
information is fully reflected in current stock prices. Finally, strong form tests of the efficient
market hypothesis are tests of whether all information, both public and private (or inside), is
fully reflected in security prices and whether any type of investor is able to earn excess returns.
Empirical Tests of Weak Form Efficiency
The weak form of the efficient market hypothesis (EMH) says that the current prices of
stocks already fully reflect all the information that is contained in the historical sequence of
prices. The new price movements are completely random. They are produced by new pieces of
information and are not related or dependent on past price movements. Therefore, there is no
benefit in studying the historical sequence of prices to gain abnormal returns from trading in
securities. This implies that technical analysis, which relies on charts of price movements in the
past, is not a meaningful analysis for making abnormal trading profits.
The weak form of the efficient market hypothesis is thus a direct repudiation of technical
analysis.
Two approaches have been used to test the weak form of the efficient market hypothesis.
One approach looks for statistically significant patterns in security price changes.
The alternative approach searches for profitable short-term trading rules.
Serial Correlation Test
Since the weak form EMH postulates independence between successive price changes,
such independence or randomness in stock price movements can be tested by calculating the
correlation between price changes in one period and changes for the same stock in another
period. The correlation coefficient can take on a value ranging from —1 to 1; a positive number
indicates a direct relation, a negative value implies an inverse relationship and a value close to

24
zero implies no relationship. Thus, if correlation coefficient is close to zero, the price changes
can be considered to be serially independent.
Run Test
The run test is another test used to test the randomness in stock price movements. In this
test, the absolute values of price changes are ignored; oly the direction of change is considered.
An increase in price is represented by + signs. The decrease is represented by – sign. When there
is no change in prices, it is represented by ‘O’. A consecutive sequence. Of the same sign is
considered as a run.
For example, the sequence + + + — — — has two runs. In other words, a change of sign
indicates a new run. The sequence — — — + + 0 — — — + + + + has five runs; a run of three
— ‘s, followed by a run of two + ‘s, another run of one 0, a fourth run of three — ‘s and a fifth
run of four + ‘s. In a run test, the actual number of runs observed in a series of stock price
movements is compared with the number of runs in a randomly generated number series. If no
significant differences are found, then the security price changes are considered to be random in
nature.
Filter Tests
If stock price changes are random in nature, it would be extremely difficult to develop
successful mechanical trading systems. Filter tests have been developed as direct tests of specific
mechanical trading strategies to examine their validity and usefulness.
It is often believed that, as long as no new information enters the market, the price
fluctuates randomly within two barriers—one lower, and the other higher—around the fair price.
When new information comes into the market, a new equilibrium price will be determined. If the
news is favorable, then the price should move up to a new equilibrium above the old price.
Investors will know that this is occurring when the price breaks through the old barrier. If
investors purchase at this point, they will benefit from the price increase to the new equilibrium
level.
Likewise, if the news received is unfavorable, the price of the stock will decline to a
lower equilibrium level. If investors sell the stock as it breaks the lower barrier, they will avoid
much of the decline. Technicians set up trading strategies based on such patterns to earn excess
returns.
The strategy is called a filter rule. The filter rule is usually stated in the following way:
Purchase the stock when it rises by x per cent from the previous low and sell it when it declines
by x per cent from the subsequent high. The filters may range from 1 per cent to 50 per cent or
more. The alternative to this active trading strategy is the passive buy and hold strategy.
The returns generated by trading according to the filter rule are compared with the returns
earned by an investor following the buy and hold strategy. If trading with filters results in
superior returns that would suggest the existence of patterns in price movements and negate the
weak form EMH.
Distribution Pattern
It is a rule of statistics that the distribution of random occurrences will conform to a
normal distribution. Then, if price changes are random, their distribution should also be
approximately normal. Therefore, the distribution of price changes can be studied to test the
randomness or otherwise of stock price movements.
In the 1960s the efficient market theory was known as the random walk theory. The
empirical studies regarding share price movements were testing whether prices followed a
random walk.

25
 Two articles by Roberts and Osborne, both published in 1959, stimulated a great deal of
discussion of the new theory then called random walk theory.
Roberts’ study compared the movements in the Dow Jones Industrial Average (an
American stock market index) with the movement of a variable generated from a random walk
process. He found that the random walk process produced patterns which were very similar to
those of the Dow Jones index.
Osborne’s study found a close resemblance between share price changes and the random
movement of small particles suspended in a solution, which is known in Physics as the Brownian
motion. Both the studies suggested that share price changes are random in nature and that past
prices had no predictive value.
During the 1960s there was an enormous growth in serial correlation testing. None of
these found any substantial linear dependence in price changes. Studies by Moore, Fama and
Hagerman and Richmond are some of the early studies in this area. Moore found an average
serial correlation coefficient of — 0.06 for price changes measured over weekly intervals.
Fama’s study tested the serial correlation for the thirty stocks comprising the Dow Jones
industrial average for the five years prior to 1962. The average serial correlation coefficient was
found to be 0.03. Both the coefficients were not statistically different from zero; thus both the
studies supported the random walk theory.
Fama also used run tests to measure dependency. The results again supported the random
walk theory. Many studies followed Moore’s and Fama’s work each of which used different
databases. The results of these studies were much the same as those of Moore and Fama.
Hagerman and Richmond conducted similar studies on securities traded in the ‘over- the-
counter’ market and found little serial correlation. Serial correlation tests of dependence have
also been carried out in various other stock markets around the world. These have similarly
revealed little or no serial correlation.
Much research has also been directed towards testing whether mechanical trading
strategies are able to earn above average returns. Many studies have tested the filter rules for its
ability to earn superior returns. Early American studies were those by Alexander, who originally
advocated the filter strategy, and by Fama and Blume. There were similar studies in the United
Kingdom by Dryden and in Australia by Praetz. All these studies have found that filter strategies
did not achieve above average returns. Thus, the results of empirical studies have been virtually
unanimous in finding little or no statistical dependence and price patterns and this has
corroborated the weak form efficient market hypothesis
Empirical Tests of Semi-Strong Form Efficiency
The semi-strong form of the efficient market hypothesis says that current prices of stocks
not only reflect all informational content of historical prices, but also reflect all publicly
available information about the company being studied. Examples of publicly available
information are—corporate annual reports, company announcements, press releases,
announcements of forthcoming dividends, stock splits, etc. The semi-strong hypothesis maintains
that as soon as the information becomes public the stock prices change and absorb the full
information. In other words, stock prices instantaneously adjust to the information that is
received.
The implication of semi-strong hypothesis is that fundamental analysts cannot make
superior gains by undertaking fundamental analysis because stock prices adjust to new pieces of
information as soon as they are received. There is no time gap in which a fundamental analyst
can trade for superior gains. Thus, the semi-strong hypothesis repudiates fundamental analysis.

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 Semi-strong form tests deal with whether or not security prices fully reflect all publicly
available information. These tests attempt to establish whether share prices react precisely and
quickly to new items of information. If prices do not react quickly and adequately, then an
opportunity exists for investors or analysts to earn excess returns by using this information.
Therefore, these tests also attempt to find if analysts are able to earn superior returns by using
publicly available information.
There is an enormous amount and variety of public information. Semi-strong form tests
have been performed with respect to many different types of information. Much of the
methodology used in semi-strong form tests has been introduced by Fama, Fisher, Jensen and
Roll. Theirs was the first of the studies that were directly concerned with the testing of the semi-
strong form of EMH. Subsequent to their study, a number of refinements have been developed in
the test procedure.
The general methodology followed in these studies has been to take an economic event
and measure its impact on the share price. The impact is measured by taking the difference
between the actual return and expected return on a security. The expected return on a security is
generally estimated by using the market model (or single index model) suggested by William
Sharpe. The model used for estimating expected returns is thefollowing:
Ri = ai + biRm + ei
Where
Ri = Return on security i.
Rm = Return on a market index.
ai& bi = Constants.
ei = Random error.
This analysis is known as Residual analysis. The positive difference between the actual
return and the expected return represents the excess return earned on a security. If the excess
return is close to zero, it implies that the price reaction following the public announcement of
information is immediate and the price adjusts to a new level almost immediately. Thus, the lack
of excess returns would validate the semi-strong form EMH.
Major studies on the impact of capitalization issues such as stock splits and stock
dividends have been conducted in the United States by Fama, Fisher, Jensen and Roll and
Johnson, in Canada by Finn, and in the United Kingdom by Firth. All these studies found that the
market adjusted share prices instantaneously and accurately for the new information. Both Pettit
and Watts have investigated the market’s reaction to dividend announcements. They both found
that all the price adjustment was over immediately after the announcement and thus, the market
had acted quickly in evaluating the information.
Other items of information whose impact on share prices have been tested include
announcements of purchase and sale of large blocks of shares of a company, takeovers, annual
earnings of companies, quarterly earnings, accounting procedure changes, and earnings estimates
made by company officials. All these studies which made use of the
Residual analysis approach, showed the market to be relatively efficient.
Ball and Brown tested the stock market’s ability to absorb the informational content of
reported annual earnings per share information. They found that companies with good earnings
report experienced price increase in stock, while companies with bad earnings report experienced
decline in stock prices. But surprisingly, about 85 per cent of the informational content of the
earnings announcements was reflected in stock price movements prior to the release of the actual

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earnings figure. The market seems to adjust to new information rapidly with much of the impact
taking place in anticipation of the announcement.
Joy, Litzenberger and McEnally tested the impact of quarterly earnings announcements
on the stock price adjustment mechanism. Some of their results, however, contradicted the semi-
strong form of the efficient market hypothesis. They found that the favorable information
contained in published quarterly earnings reports was not always instantaneously adjusted in
stock prices. This may suggest that the market does not adjust share prices equally well for all
types of information.
By way of summary it may be stated that a great majority of the semi- strong efficiency
tests provide strong empirical support for the hypothesis; however, there have been some
contradictory results too. Most of the reported results show that stock prices do adjust rapidly to
announcements of new information and that investors are typically unable to utilize this
information to earn consistently above average returns.
Tests of Strong Form Efficiency
The strong form hypothesis represents the extreme case of market efficiency. The strong
form of the efficient market hypothesis maintains that the current security prices reflect all
information both publicly available information as well as private or inside information. This
implies that no information, whether public or inside, can be used to earn superior returns
consistently.
The directors of companies and other persons occupying senior management positions
within companies have access to much information that is not available to the general public.
This is known as inside information. Mutual funds and other professional analysts who have
large research facilities may gather much private information regarding different stocks on their
own. These are private information not available to the investing public at large.
The strong form efficiency tests involve two types of tests. The first type of tests attempt
to find whether those who have access to inside information have been able to utilize profitably
such inside information to earn excess returns. The second type of tests examine the performance
of mutual funds and the recommendations of investment analysts to see if these have succeeded
in achieving superior returns with the use of private information generated by them.
Jaffe, Lorie and Niederh offer studied the profitability of insider trading (i.e. the
investment activities of people who had inside information on companies). They found that
insiders earned returns in excess of expected returns. Although there have been only a few
empirical studies on the profitability of using inside information, the results show, as expected,
that excess returns can be made. These results indicate that markets are probably not efficient in
the strong form.
Many studies have been carried out regarding the performance of American mutual funds
using fairly sophisticated evaluation models. All the major studies have found that mutual funds
did no better than randomly constructed portfolios of similar risk. Firth studied the performance
of Unit Trusts in the United Kingdom during the period 1965— 75. He also found that unit trusts
did not outperform the market index for their given levels of risk. A small research has been
conducted into the profitability of investment recommendations by investment analysts. Such
studies suggest that few analysts or firms of advisers can claim above average success with their
forecasts.
The results of research on strong form EMH may be summarized as follows:
1. Inside information can be used to earn above average returns.

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2. Mutual funds and investment analysts have not been able to earn superior returns by using
their private information.
In conclusion, it may be stated that the strong form hypothesis is invalid as regards inside
information, but valid as regards private information other than inside information.
EMH Vs. Fundamental and Technical Analyses
There are three broad theories concerning stock price movements. These are the
fundamental analysis, technical analysis and efficient market hypothesis. Fundamental analysts
believe that by analyzing key economic and financial variables they can estimate the intrinsic
worth of a security and then determine what investment action to take.
Fundamental analysis seeks to identify under priced securities and overpriced securities.
Their investment strategy consists in buying under priced securities and selling overpriced
securities, thereby earning superior returns.
A technical analyst maintains that fundamental analysis is unnecessary. He believes that
history repeats itself. Hence, he tries to predict future movements in share prices by studying the
historical patterns in share price movements.
The efficient market hypothesis is expressed in three forms. The weak form of the
EMH directly contradicts technical analysis by maintaining that past prices and past price
changes cannot be used to forecast future price changes because successive price changes are
independent of each other. The semi-strong form of the EMH contradicts fundamental analysis to
some extent by claiming that the market is efficient in the dissemination and processing of
information and hence, publicly available information cannot be used consistently to earn
superior investment returns.
The strong form of the EMH maintains that not only is publicly available information
useless to the investor or analyst but all information is useless.
Even though the EMH repudiates both fundamental analysis and technical analysis, the
market is efficient precisely because of the organized and systematic efforts of thousands of
analysts undertaking fundamental and technical analysis. Thus, the paradox of efficient market
hypothesis is that both fundamental and technical analyses are required to make the market
efficient and thereby validate the hypothesis.
Competitive Market Hypothesis
An efficient market has been defined as one where share prices always fully reflect
available information on companies. In practice, no existing stock market is perfectly efficient.
There are evident shortcomings in the pricing mechanism. Often, the complete body of
knowledge about a company’s prospects is not publicly available to market participants. Further,
the available information would not be always interpreted in a completely accurate fashion. The
research studies on EMH have shown that price changes are random or independent and hence
unpredictable. The prices are also seen to adjust quickly to new information. Whether the price
adjustments are correct and accurate, reflecting correctly and accurately the meaning of publicly
available information is difficult to determine.
All that can be validly concluded is that prices are set in a very competitive market, but
not necessarily in an efficient market. This competitive market hypothesis provides scope for
earning superior returns by undertaking security analysis and following portfolio management
strategies.
Market Inefficiencies
Many studies have proved the prevalence of the market efficiency. At the same time,
several studies contradict the concept of market efficiency. For example, the studies conducted

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Joy, Lichtenberger and Mc. Enally over the period of 1963-1968 gave different results. The
authors have examined the quarterly earnings of the stock prices. The earning of one quarter was
compared with the same quarter of the previous year. If the current year’s earnings were 40% or
more than the earnings for the same quarter in the previous year, the earnings were classified as
good earnings than anticipated. If the current quarter’s earnings were below 40% of the previous
year’s earnings, they are classified as bad than expected.
Then the abnormal returns were calculated from 13 weeks prior to the announcement of
the earnings to 26 weeks after the announcement of the earnings. The stocks whose earnings are
substantially greater than anticipated gave positive abnormal returns. The stocks whose earnings
are below the anticipated earnings generated negative abnormal returns.
The author’s main claim is that after the announcement of the earnings, stocks that
reported earnings substantially above those of the previous year continued to earn positive
abnormal returns. According to the study, the investors could have earned positive abnormal
returns of around 6.5 per cent over the next 26 weeks simply by buying stocks that have reported
earnings 40% above the previous quarterly earnings. Meanwhile for those stocks with earnings
substantially below the previous year, the cumulative average abnormal return remained
relatively stable. This shows evidence against the semi-strong market hypothesis because it states
that when the information is made public the analyst could not earn abnormal profits. A study
made by C.P. Jones, R. S. Randleman for the period 1971-1980 had also given similar results to
those of JLM.
Low PE effect many studies have provided evidences that stocks with low price earnings
ratios yield higher returns than stocks with higher PEs. This is known as low PE effect. A study
made by Basu in 1977 was risk adjusted return and even after the adjustment there was excess
return in the low price-earnings stocks. If historical information of P/E ratios is useful to the
investor in obtaining superior stock returns, the validity of the semi-strong form of market
hypothesis is questioned. His results stated that low P/E portfolio experienced superior returns
relative to the market and high P/E portfolio performed in an inferior manner relative to the
overall market. Since his result directly contradicts semi-strong form of efficient market
hypothesis, it is considered to be important.
Small firm effect the theory of the small firm effect maintains that investing in small
firms (those with low capitalization) provides superior risk adjusted returns. Bans found that the
size of the firm has been highly correlated with returns. Bans examined historical monthly
returns of NYSE common stocks for the period 1931-1975. He formed portfolios consisting of
10 smallest firms and the 10 largest firms and computed the average return for these portfolios.
The small firm portfolio has outperformed the large firm portfolio.
Several other studies have confirmed the existence of a small firm effect. The size effect
has given rise to the doubts regarding the risk associated with small firms. The risk associated
with them is underestimated and they do not trade as frequently as the of the large firms. Correct
measurement of risk and return of small portfolios tends to eliminate at least 50% of the small
firm effect.
The weekend effect French in his study had examined the returns generated by the
Standard and poor Index for each day of the week. Stock prices tend to rise all week long to a
peak on Fridays. The stocks are traded on Monday at reduced prices, before they begin the next
week’s price rise. Buying on Monday and selling on Friday from 1953 to 1977 would have
generated average annual return 3.4% while simple buy and hold would have yielded

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 5.5% annual return. If the transaction costs are taken into account, the naive buy and hold
strategy would have provided higher return. Yet the knowledge of the weekend effect is still of v
Purchases planned on Thursday or Friday can be delayed until Monday, while sale planned for
Monday can b delayed until the end of the week. The weekend effect is a small but significant
deviation from perfectly random price movements and violates the weekly efficient market
hypothesis.
Similar to this Venkatesh B. of the BL Research Bureau has stated that the Bombay Stock
Exchange reveal a discernible pattern. Usually, Monday, is characterized by trading blues, and
Friday by frenzied activity The Friday rush is more to do with speculators covering their open
position. If the short sellers to cover their position within this period, their open positions are
called to auction where prices are dear.
Summary
1. the technical analysts studies the behaviour of the price of the stock to determine the future
price of the –stock
2. According to Charles H. Dow, stock price movements are divided into three: the primary
movement, the secondary movement and the daily fluctuations.
3. A primary trend may be a bull market moving in a steady upward direction, or a bear market
steadily dropping.
4. A secondary trend or secondary reaction is the movement of the market contrary to the
primary trend.
5. Support level is the barrier for further decline. It provides a base for an up move. The
resistance level is the level in which advances are temporarily stopped and the sellers
overcome the demand.
6. Volume of the trade confirms the trend. Fall of volume with the rise in price indicates trend
reversal and vice-versa.
7. Breadth of the market is the net number of stocks advancing versus, those declining in the
market. If the Al D line slopes downward while the Sensex is rising, it gives a bearish signal
and vice-versa.
8. Moving averages are used as a technical indicator. It smoothens out the short term
fluctuations, helpful in comparing the stock price movement with the index movement and
discovering the trend.
9. Oscillators show the market or scrip momentum to find out the overbought and oversold
conditions of the market or scrip. Relative strength index and rate of change index are the
commonly used oscillators.
10. Charts are the major analytical tools used in technical analysis. Point and figure chart is one-
dimensional chart drawn to predict the extent and direction of the price movement. Ordinary
bar charts generate numerous patterns. These patterns indicate the trend and the trend
reversals.

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